adal finance

8/7/2019 adal finance

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Financial management: lecture 10

Capital Structure Decision

MM propositions


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Todays plan

Review what we have learned in the lastlecture

The capital structure decision The capital structure without taxes MMs proposition 1 MMs proposition 2

The capital structure with taxes MMs proposition 1 MMs proposition 2


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What have we learned in the

last lectureIn the last lecture, we have discussedthe case in the end of chapter 12, what

have you learned from this case?In the last lecture, we have alsodiscussed three forms of market

efficiency, what are they and what isyour understanding of these three formsof market efficiency?


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Look at the both sides of a

balance sheetAsset Liabilities and equity

Market value of the assetV

Market value of equity

EMarket value of debt

D

V=E+D


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Capital structureCapital structure refers to the mix of debt andequity in a firm.

We often use D/E or D/V (V=D+E) to indicatethe capital structure of a firm. Usually, the higher the ratio, the more debt a firm has

The capital structure problem for a firm is to

determine what is the maximum amount of debt a firm should have to maximize the firmsvalue.


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Does capital structure affect the

firm value?

Equity Debt

Equity

Equity

DebtDebt

Govt.Govt.

Slicing the pie doesntaffect the total amount

available to debtholders and equity holders

Slicing the pie can

affect the size of the slicegoing to government

Slicing the pie canaffect the size of the

wasted slice

wasted


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MMs proposition 1

Modigliani & Miller If the investment opportunity is fixed, there

are no taxes, and capital markets functionwell, the market value of a company does notdepend on its capital structure.

How can we understand this?

The size of a pizza has nothing to do with howyou slice it.


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MMs proposition 2Modigliani & Miller If the investment opportunity is fixed, there are no

taxes, and capital markets function well, theexpected rate of return on the common stock of alevered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.

The WACC is independent of how the firm isfinanced


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r

DV

r D

r E

WACC

WACC without taxes in MMs view


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Example - River Cruises - All Equity Financed

17.5%12.5%7.5%sharesonReturn

1.751.25$.75share per Earnings175,000125,000$75,000IncomeOperatingBoomExpectedSlump

Economytheof State Outcome

million1$Sharesof ValueMarket$10share per Price100,000sharesof Number

Data

M&M (Debt Policy Doesnt Matter)


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Example cont.50% debt

25%15%5% shareson Return

2.501.50$.50share per Earnings125,00075,000$25,000earningsEquity50,00050,000$50,000Interest175,000125,000$75,000IncomeOperating

BoomExpectedSlump


500,000$debtof ueMarket val500,000$Sharesof ValueMarket

$10share per Price50,000sharesof Number

Data



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Example - River Cruises - All Equity Financed- Debt replicated by investors

25%15%5%investment $10on Return

2.501.50$.50investmentonearnings Net1.001.00$1.0010%@Interest:LESS

3.502.50$1.50sharestwoonEarningsBoomExpectedSlump




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The use of debt has a lot of implications: Financial risk- The use of debt will increase the risk to

share holders and thus Increase the variability of shareholder returns.

Interest tax shield- The savings resulting fromdeductibility of interest payments.

Capital structure and CorporateTaxes


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You own all the equity of Space Babies Diaper Co.. The company has no debt. The companysannual cash flow is $1,000, before interest and

taxes. The corporate tax rate is 40%. You havethe option to exchange 1/2 of your equity positionfor 10% bonds with a face value of $1,000.

Should you do this and why?

An example on Tax shield


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All Equity 1/2 Debt

EBIT 1,000

Interest Pmt 0

Pretax Income 1,000

Taxes @ 40% 400

Net Cash Flow $600

C.S. & Corporate Taxes


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All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Pretax Income 1,000 900

Taxes @ 40% 400 360Net Cash Flow $600 $540

C.S. & Corporate Taxes


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Capital Structure and CorporateTaxes

All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100Pretax Income 1,000 900

Taxes @ 40% 400 360

Net Cash Flow $600 $540

Total Cash Flow

All Equity = 600

*1/2 Debt = 640 *1/2 Debt = 640

(540 + 100)


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Capital Structure and tax shield

PV of Tax Shield =

D x r D x Tc

r D= D x Tc

Example:

Tax benefit = 1000 x (.10) x (.40) = $40

PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400


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MMs proposition 1 with tax

firm value = value of all equity firm + PV(taxshield)

Example,all equality firm value =600/0.1=6,000PV( tax shield)=400

firm value=6,400


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MMs proposition 2

The weighted average cost of capital isdecreasing with the ratio of D/E, that is

Can you understand this intuitively?

++

+= E D E

r E D

Dr T WACC equitydebt c )1(


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WACC Graph


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Financial Distress

Costs of Financial Distress - Costs arising frombankruptcy or distorted business decisionsbefore bankruptcy.

Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial

Distress


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Financial distress

Costs of Financial Distress - Costs arising frombankruptcy or distorted business decisions beforebankruptcy.

Market Value = Value if all Equity Financed + PV Tax Shield

- PV Costs of Financial Distress


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Optimal Capital structure

Trade-off Theory - Theory that capital structureis based on a trade-off between tax savingsand distress costs of debt.

Pecking Order Theory - Theory stating thatfirms prefer to issue debt rather than equity if

internal finance is insufficient.


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Financial Distress

Debt

MarketValueofTheFirm

Value of unlevered

firm

PV of interesttax shields

Costs of financial distress

Value of levered firm

Optimal amountof debt

Maximum value of firm

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